Quick Correction in Gold or the First Part of a Bigger Decline?

Nowadays one can safely say that gold has come around full circle, its shine
untarnished by the passing years as it has reclaimed its respected place at
the heart of the financial system. The debate over a return to the gold standard
has resurfaced in the last few years in a way that has not been seen in the
four decades since 1971 when President Richard Nixon decided to severe the
dollar's ties to gold. Gold is shining brightly.

Robert Zoellick, president of the World Bank, wrote in the Financial Times
opinion piece last year about a new monetary system involving a basket of currencies
that "should also consider employing gold as an international reference point
of market expectations about inflation, deflation and future currency values" Zoellick
then added: "Although textbooks may view gold as the old money, markets are
using gold as an alternative monetary asset today."

Central banks have become significant buyers once again. World Gold Council
figures show that central banks bought about 208 tons of gold in the first
half of this year. There were significant purchases by Thailand, Mexico and
South Korea in recent months. This comes at a time when the sovereign debt
crisis in the eurozone is spiraling and the downgrading of the U.S. credit
rating has sparked waves of volatility and fears of another global recession.
Governments are running out of rabbits they can pull out of the hat to absorb
new shocks. The recent debt ceiling debate revealed a political dysfunction
that undermines U.S. status even more than the S&P decision to cut its
triple-A rating.

Venezuela has found a "creative" way to increase its gold reserves. It just
announced last week that it is planning to nationalize its gold industry. Since
emerging market central banks are now only gearing up for gold buying spree,
the sovereign sector might provide a solid floor for gold prices for the foreseeable
future.

If the period before the "Nixon Shock" was one of the best, the decade following
his announcement had one of the worst inflations of American history and the
most stagnant economy since the Great Depression. The price of gold rose to
$800 from $35. If you had a dollar in 1971, today it would be worth only about
18 pennies.

One of the most significant results of Nixon's decision was the consequent
liberalization of the financial markets which began in the 1970s picking up
speed in the 1980s. This was a time of the lifting of exchange controls and
the abandonment of formal restrictions on credit. The only instrument left
in the arsenal of governments to control the availability of credit is now
interest rates. That's when the good times began to roll and nations and individuals
began amassing debt.

Looking back in hindsight, it is possible that if not for the "Nixon Shock" we
would have avoided the financial crisis of the past four years; or indeed the
crisis after crisis that have plagued world markets. We can say for certain
that the whole debate on the debt ceiling that we witnessed a few weeks ago
would have never taken place.

With so much information from the past, we are well equipped to deal with
the future. And the future is what are technical part is particularly concentrated
on. This time, we will start with the long-term gold chart (charts courtesy
by http://stockcharts.com.)

In this chart we see, that the price of gold has moved above the highs that
were seen last week. Gold moved very close to the $1,900 level which is a move
above the previous highs. This is a breakout above the previous top; however
given this week's decline we don't think that the outlook is bullish.

The situation was extremely overbought from a short-term point of view and
previous signals from volume levels are still very much in play, so the current
move lower is not something unexpected. In late 2009, a local top turned out
to really be a pre-top about a week before the final top was seen. This was
also accompanied by significant volume levels.

On August 16th in our essay on the possible top
in gold we made the following observations:

The current RSI level indicates an overbought situation and, in the past,
this has usually been followed by a decline in gold's price. Volume levels
are also giving a similar signal. This has often coincided with local tops
in the past. Normally, a quick downturn usually follows. It does seem that
we are now at a local top for gold or very close to it.

The current situation on the market suggests that these remarks are very much
up-to-date, despite the fact that gold has moved higher recently.

In the long-term chart for gold from a non-USD perspective, we see that gold's
price has once again moved to the upper border of the rising, long-term trend
channel created by the February 2009 and May 2010 highs and that it has continued
its move up. Whether this is a real breakout remains to been seen as the situation
is quite overbought on a short-term basis with the RSI above the 80-level.
Based on the current move lower, it seems that the history repeats itself once
again and gold will move lower after reaching this important resistance.

Looking at gold from the perspective of the Japanese yen, we see a situation
here similar to the non-USD perspective. The index level has also reached a
resistance line once again, no significant breakout has been seen and the situation
is extremely overbought.

A confirmation of the doubts concerning the momentum of gold comes from the
analysis of the silver:gold ratio.

In the silver to gold ratio chart, we see that the ratio is now once again
below the rising trend channel in the chart, and this is generally a bearish
sign. Such a situation has, in fact, only been seen once before. This was in
2008 right before prices plunged. The general stock market also declined sharply
at that time (note: we're not bearish on stocks at this time) and it influenced
the silver to gold ratio in a negative way since silver is more closely aligned
with stocks.

The ratio declines when silver's price drops more rapidly than gold's on a
percentage basis. This is because silver's price is in the numerator of the
ratio. A significant decline in the ratio may be underway once again where
silver prices could drop more rapidly than gold's. It seems that extreme caution
is necessary for all long speculative positions in silver or gold at this time.

Summing up, gold has likely confirmed its local (not the final one
for this bull market) top recently and we believe the decline will continue.

At this point, we have somewhat ambiguous feelings towards gold. One part
of us, the part that feels gold should always be part of our portfolio has
been very happy with gold's previous spectacular performance. On the other
hand, the other part of us, the contrarian one, does not at all like what has
happened recently. There has simply been too much of a push towards buying
gold in the media and the fact is that no market can only look in one direction
without eventually correcting.

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Przemyslaw Radomski, CFA (PR) is a precious metals investor and analyst who
takes advantage of the emotionality on the markets, and invites you to do
the same.

His company, Sunshine Profits, publishes analytical software that anyone can
use in order to get an accurate and unbiased view on the current situation.

Recognizing that predicting market behavior with 100% accuracy is a problem
that may never be solved, PR has changed the world of trading and investing
by enabling individuals to get easy access to the level of analysis that
was once available only to institutions.

High quality and profitability of analytical tools available at www.SunshineProfits.com are
results of time, thorough research and testing on PR's own capital.

PR believes that the greatest potential is currently in the precious metals
sector. For that reason it is his main point of interest to help you make
the most of that potential.

As a CFA charterholder, Przemyslaw Radomski shares the highest standards for
professional excellence and ethics for the ultimate benefit of society.

Disclaimer: All essays, research and information found above represent
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